Archives For
investing

Any smart investor is going to look to look to both protect their investments while also securing the best return possible. It is always a juggling act for any investor, regardless of how much experience he/she may have. Investment tracking is quite a task. While there are many important ways to accomplish this balance, diversification is one of best ways to accomplish both values.

A risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique contends that a portfolio of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio.

Diversification strives to smooth out unsystematic risk events in a portfolio so that the positive performance of some investments will neutralize the negative performance of others. Therefore, the benefits of diversification will hold only if the securities in the portfolio are not perfectly correlated.

Why Diversification is Important

Diversification is important, as I mentioned above, because it allows you to accomplish two things at once. The first, and perhaps more important, is to protect yourself from any significant loss. The basic idea is that one area of the market is performing poorly, the others will make up for it. It is also very unlikely for all markets or investments within a market to drop significantly at one time. The risk is inherently lower despite taking a more aggressive investment strategy.

The other major benefit to diversification is the ability to maintain an aggressive approach and thereby maximizing long-term return. Instead of sticking to conservative investments like bonds or cd’s, diversified investors are able to keep their money in high-yielding investments.

How to Diversify Your Investments

While a lot (maybe enough to fit in entire books) could be said about how to actually diversify your investments, I thought I would give you a picture of what I am doing to diversify my portfolio. Keep in mind that my investment history is quite short and over the next few years I plan to diversify it even further.

Employer 403b Account – One of the best ways to start investing is with your employer’s investment account. It often comes with some form of matching, so it automatically gives you a great return on your investment. I personally have mine set up with a mutual fund because of how little is being invested. It provides for some inherent diversification.

Real Estate Investing – One of the ways I am in the process of investing in over the next few months is real estate investing. I believe this to be a secure investment for decades to come and the revenue stream should only increase with inflation.

Dividend Stocks – While I am not an expert on dividend stocks, I have been learning a lot about the benefits of investing in dividend stocks. In fact, dividend stocks over a period from 1972 to 2010 provided a significantly larger return than non-dividend stocks. Dividend stocks offer some minor diversification as there are two revenue streams. The first is the dividend as a form of cash flow and the other in the potential increase in the stock value. If you want to learn more about dividend stocks, there are many great resources like the list of high yield dividend stocks by Dividend Stocks Online.

Side Business – Another way that I am trying to diversify my investments is to build up a side business for myself. Eventually I would like to see it develop into my full-time gig, but I have to sustain a decent income before I make that leap.

While diversification can (and often is) be simplified to investing in mutual funds or ETFs, it is much more than that. It should include different investment vehicles and markets.

On Friday, Free Money Finance posted a link to Sound Mind Investing’s new and free ebook about investing in gold. You can sign up to get the ebook here if you’re interested. I’ve been reading about this issue of gold, inflation, and the declining dollar for a bit now so I thought I’d check it out.

After reading it, I headed back to FMF’s site to leave a comment and was pleased to find an insightful comment from Rick Francis who writes at Pondering Money. Rick’s question was this: If you believe that the dollar will weaken, political gridlock will continue, and that these are bad things, why not hedge against inflation with something that hasn’t had a “meteoric” (as SMI puts it) price increase? And while you’re at it, why not choose a commodity that actually has practical uses like oil, real estate, or food? (Or if you’re really worried, shotgun shells and bottled water…my words, not Rick’s.)

Take, for example, copper. Copper has a large number of practical applications while gold has only a limited few. Now I’m not saying copper is the right choice. I’m just giving you an example. Oil could be another good example.

Here’s another one: real estate. Or even better, how about real estate with a commodity on it – land with standing timber. Again, I’m not saying these are the ideal alternatives for gold. Rather, I’m simply trying to make the point that there are some other commodities that you can make a better case for investing in than gold. So don’t try to take me to task for a possibly poor choice of replacements. The question still stands: can we find no better, more useful, more reasonably priced commodity to use as a hedge against inflation than gold?

In all my reading about investing (especially online), I’ve noticed a disturbing trend. People tend to talk about investing in terms of their beliefs. One might say, “I don’t believe people can’t beat the market. You can find good stocks by using your brain and analyzing information. I believe in active investing.” Another says, “I don’t believe anyone can beat the market. Most professional fund managers can’t do it consistently, and you probably can’t either. I believe in passive investing.” Still others say, “Market timing doesn’t work. It’s like predicting the future. I don’t believe in trying to time the market.” While some argue, “You CAN time the market if you know how. I believe it is possible to miss the bad days and save yourself a lot of money. I believe in market timing.”

What’s Missing?

You know what’s missing in most of these “belief” statements? Data. Facts. Testable, verifiable information. Knowledge. You don’t often hear people say “I know active investing works.” unless they’re talking about anecdotal evidence. And sadly, you don’t often hear people say “I know passive investing works.” They believe it because someone else believes it. Or because someone else told them to believe it. Or because it just “makes sense”. (This is true of any investment philosophy…)

Check Your Facts

The thing is we have data, albeit historical data, but data nonetheless. We can’t guarantee that the future will look like the past, but we can learn some valuable lessons from it. We can learn that it is absolutely true that most people don’t beat an appropriate market benchmark consistently. (And when I say most people I mean 90%+ and by consistently I mean at least 10+ years in a row.) And we can verify data about market timing by looking at the results of those who try it.

Then we get into the dangerous area of trying to predict the future. We make conjectures about what we think may or may not happen in the future. Then we build up our investment philosophy around that. Too often, we build it only on those conjectures and ignore all the data. And that’s the problem I’m seeing.

Belief or Reality?

I’m not going to get into the details of what we think we know and don’t know. I simply want to ask you to think the next time you talk about your investing “beliefs”. Are you basing your beliefs on facts, data, and information you can test? Or are you basing it completely on feelings, conjectures, and guesses about the future or what makes sense to you?